The Changing Climate of Credit Risk Management

By Amnon Levy and Frank Freitas

While credit portfolio managers generally recognize that physical climate risk needs to be accounted for, questions and misconceptions abound. The potential manifestations of climate change and their impacts on economic outcomes are only beginning to be understood, and it is likely that investments in resilience and risk reduction will lag understanding.

While bankers are increasingly managing risks related to changes in policy and technology (also known as transition risk), physical risks are not necessarily an obvious set of primary factors for banks’ commercial credit portfolio managers originating credit with maturities of three to seven years. Instead, market participants assume climate effects will prevail over long-term horizons, more than 20 to 30 years into the future. Thus, there is a mismatch between investment horizons and the expected arrival of climate change-driven financial effects.

Having said that, it is increasingly difficult to disassociate credit risk from climate risk. Climate effects that bankers need to consider manifest not just as gradual changes in temperature or sea levels, but also as increases in the frequency and intensity of acute weather events. The past few years have produced several record-breaking loss events, with the mounting costs of billion-dollar disasters ranging from hurricanes and typhoons to flooding and fires. The Pacific Gas and Electric bankruptcy following a 2018 California wildfire season that set records for destructiveness may be a precursor of what is to come, with obvious implications for sectors such as transportation, agriculture and energy. The result is driving bankers (and insurance companies) to be ever more cognizant of the need to quantify these risks and their impacts across banks’ portfolios. From real estate exposures to loan books, virtually no asset class is immune to these increased risks.

A less obvious and certainly less discussed—but possibly the most important—financial factor that should drive credit portfolio managers to consider climate change impacts on their portfolios is the association between a firm’s enterprise value, credit quality and long-run cash-flow generation. As a rule, more than half a firm’s value can be attributed to cash flows beyond 20 or 30 years. In our view, a firm’s viability and creditworthiness can vary materially across climate scenarios that may unfold over the relatively short horizon of three to five years and become increasingly compromised during that shorter time horizon.

Climate change effects on corporations can take many forms. Understanding these pathways is a critical step to the evaluation and management of risks. First, climate change can affect a firm’s value directly and across the value chain through both acute and chronic pathways. Extreme weather can disrupt supply chains, render facilities inoperable and compromise consumers’ ability to purchase goods and services that are the outputs of corporate activities. Climate change can also indirectly influence corporate viability by negatively influencing the broader environment within which corporations operate—resulting, for example, in large-scale population migration, ecosystem collapse and loss of social license to operate. Both direct and indirect effects can affect corporate performance and therefore require quantitative rigor and diligence to model.

Companies can also take direct action to bolster their response to climate change and, in doing so, improve their long-term viability. Through assiduous investment in hardening of facilities and protection of employees, companies can create outcomes that benefit their shareholders as well as the communities they serve.

The misalignment of the investment holding period and the time frame in which the effects of climate change will be felt stems from misguided assumptions. We already see the economic effects of extreme weather today, and the sooner we are able to effectively model and quantify pathways between climate events and credit, the better we will be able to invest in outcomes which prevent outsized market corrections in the future.

Amnon Levy is managing director and head of portfolio and balance sheet research at Moody’s Analytics. Frank Freitas is chief development officer at Four Twenty Seven, a provider of market intelligence on the economic risk of climate change.